Question

Kolby’s Korndogs is looking at a new sausage system with an installed cost of $745,000. This cost will be depreciated straight-line to zero over the project’s 7-year life, at the end of which the sausage system can be scrapped for $103,000. The sausage system will save the firm $219,000 per year in pretax operating costs, and the system requires an initial investment in net working capital of $71,000.

a)What is the aftertax salvage value of the equipment?

Aftertax salvage value=

b) What is the annual operating cash flow?

OCF=

c) If the tax rate is 23 percent and the discount rate is 10 percent, what is the NPV of this project?

NPV=

Answer 1

a)

After tax salvage value = Market value - tax(market value - book value)

After tax salvage value = 103,000 - 0.23(103,000 - 0)

After tax salvage value = 103,000 - 23,690

After tax salvage value = 79,310

b)

Annual depreciation = 745,000 / 7

Annual depreciation = 106,428.5714

Operating cash flow from year 1 to year 7 = (Savings - depreciation)(1 - tax) + depreciation

Operating cash flow from year 1 to year 7 = (219,000 - 106,428.5714)(1 - 0.23) + 106,428.5714

Operating cash flow from year 1 to year 7 = 86,680 + 106,428.5714

Operating cash flow from year 1 to year 7 = 193,108.5714

c)

Year 7 non operating cash flow = After tax salvage value + NWC

Year 7 non operating cash flow = 79,310 + 71,000

Year 7 non operating cash flow = $150,310

Initial investment = Cost + increase NWC

Initial investment = 745,000 + 71,000

Initial investment = 816,000

NPV = Present value of cash inflows - present value of cash outflows

NPV = Annuity * [1 - 1/(1 + r)ⁿ] / r + FV / (1 +r)ⁿ - Initial investment

NPV = 193,108.5714 * [1 - 1/(1 + 0.1)⁷] / 0.1 + 150,310 / (1 +0.1)⁷ - 816,000

NPV = 193,108.5714 * 4.868419 + 77,132.79675 - 816,000

NPV = $201,266.20